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Institute of Chartered Accountants of Nigeria

Strategic Financial Management

Study Text

ICAN

ICANStrategic financial management

© Emile Woolf International ii The Institute of Chartered Accountants of Nigeria

First edition published by Emile Woolf International Bracknell Enterprise & Innovation Hub Ocean House, 12th Floor, The Ring Bracknell, Berkshire, RG12 1AX United Kingdom Email: [email protected] www.emilewoolf.com © Emile Woolf International, December 2014 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, without the prior permission in writing of Emile Woolf International, or as expressly permitted by law, or under the terms agreed with the appropriate reprographics rights organisation. You must not circulate this book in any other binding or cover and you must impose the same condition on any acquirer. Notice Emile Woolf International has made every effort to ensure that at the time of writing the contents of this study text are accurate, but neither Emile Woolf International nor its directors or employees shall be under any liability whatsoever for any inaccurate or misleading information this work could contain.

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© Emile Woolf International iii The Institute of Chartered Accountants of Nigeria

Professional level Strategic financial management

C Contents

Page

Syllabus v

Chapter

1 An introduction to strategic financial management 1

2 Regulatory background 31

3 The financial management environment 45

4 Introduction to investment appraisal 77

5 Discounted cash flow 95

6 DCF: taxation and inflation 129

7 DCF: risk and uncertainty 149

8 DCF: specific applications 171

9 Capital rationing 189

10 Working capital management 209

11 Inventory management 233

12 Management of receivables and payables 259

13 Cash management 281

14 Cost of capital 307

15 Portfolio theory and the capital asset pricing model (CAPM) 345

16 Sources of finance: equity 375

17 Sources of finance: debt 391

18 Finance for small and medium entities (SMEs) 405

Strategic financial management

© Emile Woolf International iv The Institute of Chartered Accountants of Nigeria

Page

19 A summary of features of different sources of finance 413

20 Dividend policy 421

21 Financing of projects 431

22 Business valuation 477

23 Value based management and modern business valuation techniques 507

24 Mergers and acquisitions 535

25 Corporate reconstruction and reorganisation 555

26 Evaluating financial performance 573

27 Corporate failure 595

28 Foreign exchange risk and currency risk management 611

29 International investment decisions 647

30 Interest rate risk: Hedging with FRAs and swaps 663

31 Futures and hedging with futures 687

32 Hedging with options 719

33 Option pricing theory 741

34 Emerging issues 791

Index 805

© Emile Woolf International v The Institute of Chartered Accountants of Nigeria


S Syllabus

PROFESSIONAL LEVEL

STRATEGIC FINANCIAL MANAGEMENT

Purpose

Strategic Financial Management supports management in making informed decisions. Candidates are expected to apply relevant knowledge in recommending appropriate options for financing a business, recognising and managing financial risks and investments. Professional accountants need a strong background in: Accounting, Economics, Law, Mathematics and Behavioural Sciences.

Content and competencies - overview

Grid Weighting

A Financial environment and role of financial managers 15 B Business analysis 25

C Financial analysis 25

D Mergers and acquisitions/corporate restructuring 20

E Management of financial risk 15

Total 100


© Emile Woolf International vi The Institute of Chartered Accountants of Nigeria

Contents and competencies Chapter

A Financial environment and role of financial managers a) Analyse and evaluate financial objectives within the strategic planning

process. 1

b) Assess and advise on key stakeholders of organisations and the interests of each stakeholder group.

1

c) Evaluate the impact of macroeconomics and the role of international financial institutions in strategic financial management.

2

d) Evaluate and apply the concept of Corporate Social Responsibility, its relationship to the objective of maximising shareholders’ wealth.

1

e) Assess and advise on agency theory and its relevance to financial managers.

1

f) Report on the professional, regulatory and legal framework relevant to financial management including: Stock exchange requirements, money laundering, directors’ responsibilities.

2

g) Evaluate and communicate the key activities undertaken by treasury managers.

1

h) Analyse and evaluate Centralised treasury management and the arguments for and against.

1

i) Identify and assess the impact of emerging issues in strategic financial management.

34

B Business analysis Evaluate and assess the value of businesses and shareholder value giving

advice based on business scenarios using:

a) Calculate the value of shares and businesses using appropriate investment appraisal techniques

i) Dividend yield based valuation techniques. 14, 22

ii) Price earnings ratio based valuation techniques. 22

iii) Discounted cash flow based valuation techniques. 22, 23

iv) Asset based and net asset based measures of value. 22

v) Options based techniques. 22

vi) Value based management. 23

vii) Shareholder value analysis. 23

viii) Short and long term growth rates and terminal values. 23

ix) Economic profit methods. 23

x) Cash flow return on investment. 23

xi) Total shareholder return. 23

Syllabus

© Emile Woolf International vii The Institute of Chartered Accountants of Nigeria


B Business analysis (continued) xii) Market value added. 23

xiii) Efficient Market Hypothesis (EMH) and practical considerations in the valuation of shares 22

b) Compute and discuss the effects of working capital on businesses.

i) The nature, elements and importance of working capital 10

ii) Management of inventories, accounts receivable, accounts payable and cash

11, 12, 13

iii) Determine working capital needs and funding strategies 10

c) Apply appraisal techniques and demonstrate how interpretation of results from the techniques can influence investment decisions using the following:

i) Investment appraisal techniques including:

Net Present Value 5

Adjusted Present Value 21

Internal Rate of Return 5

Payback. 4

Profitability index 9

ii) Inflation and specific price variation 6

iii) Taxation including capital allowances 6

iv) Single period and multi-period capital rationing. Multi-period capital rationing to include the formulation of linear programming technique 9

v) Specific investment decisions (lease or buy; asset replacement, capital rationing) 8

vi) Adjusting for risk and uncertainty in investment appraisal. 7

vii) Analyse and evaluate the potential economic return (using internal rate of return (IRR) and modified internal rate of return) and advise on a project’s return margin. Discuss the relative merits of NPV and IRR. 5


© Emile Woolf International viii The Institute of Chartered Accountants of Nigeria


C Financial analysis a) Identify capital requirements of business and assess financing options. 21

b) Evaluate and apply financing options for a business giving advice based on business scenarios including the use of:

i) Short, medium and long term alternatives including Islamic financing.

16-19, 34

ii) Issues of new capital. 16,17

iii) Gearing and capital structure. 21

iv) Finance for micro and small and medium sized entities (MSMEs) 18

v) Raising short and long term finance through Islamic financing 34

vi) Dividend policy. 20

c) Evaluate and apply on the effect of capital gearing on investors’ perception of financial risk and return. 21

d) Evaluate and apply on how group reconstructions, purchase of own shares and distributions using distributable profits may support financing decisions. 25

e) Evaluate and apply the cost of capital, portfolio analysis and bond evaluation based on business scenarios including the use of:

i) Cost of capital techniques including the cost of equity, debt, preference shares, bank finance, the weighted average cost of capital, convertibles and public sector discount rates. 14

ii) Portfolio theory, the capital asset pricing model, the cost of capital and the international cost of capital. 15

iii) Bond pricing using net present values. 14, 22

iv) Understanding of yields, yields to maturity, duration and price volatility, term interest rates, corporate borrowing and default risk. 14, 33

f) Develop proposals on long-term business plans from prescribed information.

No specific chapter

g) Evaluate a business plan from the perspective of an equity investor or provider of debt funding. 26

h) Compare and evaluate the financial management of an organisation with that of competitors and industry norms. 26

i) Prepare, evaluate and discuss key financial management indicators based on the published financial statements of an organisation. 26

j) Benchmarking of selected financial Key Performance Indicators (KPIs) against companies in the same industry sector. 26

Syllabus

© Emile Woolf International ix The Institute of Chartered Accountants of Nigeria


D Mergers and acquisitions/corporate restructuring a) Assess and advise on;

i) Organic and acquisitive corporate growth. 24

ii) Benefits of mergers and acquisitions to shareholders. 24

iii) Procedures to be complied with during an acquisition. 24

iv) Valuation of an organisation in the context of a potential takeover, using different methodologies. 23, 24

v) Methods of financing mergers and takeovers, including cash, debt, equity and hybrids. 24

vi) Tactics used for friendly takeovers 24

vii) Defence tactics used during a hostile takeover. 24

viii) The role of legal and financial due diligence during a merger/acquisition. 24

ix) The attractions and risks associated with Management Buy-outs (MBOs). 25

x) Sources of finance for MBOs. 25

xi) The advantages and disadvantages of management buy-ins. 25

xii) The arguments for and against a quoted company going private 25

xiii) Forms of insolvency, preparation of statement of affairs 27

b) Analyse and evaluate on the symptoms and causes of corporate failure. 27

c) Advice on avoidance of corporate failure. 27


© Emile Woolf International x The Institute of Chartered Accountants of Nigeria


E Management of financial risk a) Evaluate and apply on the financial risks of a business based on a

given scenario, data and information. 26-32

b) Assess and advise on how financial instruments such as hedging and derivative products may be used to manage risks and the nature of such products.

28, 30 - 32

c) Assess and advise on the alternative approaches to managing interest rate exposure based on a given scenario, data and information evaluating the costs of basic hedging arrangements.

30, 31, 32

d) Assess and advise on the alternative approaches to managing currency rate exposure based on a given scenario, data and information evaluating the costs of basic hedging arrangements.

28, 31, 32

e) Evaluate and apply financial and planning options for a business giving advice based on business scenarios including the use of:

i) Futures, options and swaps:

Interest rate futures. 31

Interest rate options. 32

Interest rate forward contracts. 30

Interest rate swaps. 30

ii) Foreign exchange planning:

Exchange rate determinants and risks. 28

Forward contracts. 28

Money market cover. 28

Currency options. 32

Currency swaps. 30

iii) Option values: in Capitalization

Value of a call option. 33

Value of a put option. 33

The Black Scholes option pricing model. 33

The binominal option pricing model. 33

Real option pricing. 33

© Emile Woolf International 1 The Institute of Chartered Accountants of Nigeria

Professional level Strategic Financial Management

C H

A P

T E

R

1 An introduction to strategic

financial management

Contents 1 Strategic financial management

2 Financial objectives

3 The treasury function

4 Stakeholders

5 Corporate social responsibility

6 Chapter review



INTRODUCTION

Purpose

Strategic financial management supports management in making informed decisions. Candidates are expected to apply relevant knowledge in recommending appropriate options for financing a business, recognising and managing financial risks and investments. Professional accountants need a strong background in accounting, economics, law, mathematics and behavioural sciences.

Competencies

A Financial environment and role of financial managers (a) Analyse and evaluate financial objectives within the strategic planning

process.

(b) Assess and advise on key stakeholders of organisations and the interests of each stakeholder group.

(d) Evaluate and apply the concept of Corporate Social Responsibility, its relationship to the objective of maximising shareholders’ wealth.

(e) Assess and advise on agency theory and its relevance to financial managers. (g) Evaluate and communicate the key activities undertaken by treasury

managers.

(h) Analyse and evaluate Centralised treasury management and the arguments for and against.

Exam context

This chapter provides a broad introduction to aspects of financial management. It defines strategy in order to provide a foundation for what follows. The chapter explains the impact and interaction of financial management objectives. It continues by explaining the treasury function of large organisations and continues with a discussion of stakeholders. It concludes by talking about corporate social responsibility.

Chapter 1: An introduction to strategic financial management


By the end of this chapter you will be able to:

Explain the meaning of financial strategy and strategic financial management.

Explain the formulation of corporate objectives and identify the primary corporate objective

Explain how other objectives (both financial and non-financial) link to the primary corporate objective

Explain the treasury function

Define and list stakeholders and identify their interest in an organisation

Define corporate social responsibility and explain how it links corporate objectives to stakeholder requirements



1 STRATEGIC FINANCIAL MANAGEMENT

Section overview

Definitions of strategy The nature of financial management

1.1 Definitions of strategy

There is no single definition of corporate strategy.

Definitions: Strategy

Chandler

The determination of the basic long-term goals and the objectives of an enterprise, and the adoption of courses of action and the allocation of resources necessary for carrying out these goals.

Drucker

A pattern of activities that seek to achieve the objectives of the organisation and adapt its scope, resources and operations to environmental changes in the long term.

Johnson, Scholes and Whittington

The direction and scope of an organisation over the long term, which achieves advantage in a changing environment through its configuration of resources and competencies with the aim of fulfilling stakeholder expectations.

Each of the above definitions has a different focus but all refer to actions (courses of action, pattern of activities, configuration of resources and competencies) undertaken to achieve the objectives (aim) of an organisation.

In other words:

a strategy consists of organised activities; and

the purpose of these activities (the strategy) is to achieve an objective.

Strategy is long-term. Formal strategic planning by large companies, for example, might cover five years or ten years or longer into the future.

The strategic choices that an enterprise makes are strongly influenced by the environment in which the enterprise exists. The environment is continually changing, which means that strategies cannot be rigid and unchanging.

Strategies involve an enterprise in doing different things with different resources over time, as it is forced to adapt to changes in its environment.

Financial strategy

Financial strategy is a component of the overall corporate strategy of an organisation.

Business strategies and action plans include financial strategies and plans.



1.2 The nature of financial management

Financial management refers to that aspect of management which involves planning and controlling the financial affairs of an organisation, to ensure that the organisation achieves its objectives (particularly its financial objectives).

This involves decisions about:

how much finance the business needs for its day-to-day operations and for longer-term investment projects;

where the finance should be obtained from (debt or equity) and whether it should be long term (long-term debt r equity) or short term (trade suppliers and bank overdrafts);

how to manage short term cash surpluses and short term cash deficits;

amounts to be paid out as dividends; and

how to protect the organisation against financial risks.


Strategic financial management refers to financial management on a bigger scale and with a longer time frame.

Strategic financial management is concerned with bigger decisions than financial management and those decisions might have a profound effect on the organisation.

Strategic financial management encompasses the full range of a company's finances including:

setting out objectives;

identifying resources;

analysing data;

making financial decisions; and

monitoring performance to identify problems.



2 FINANCIAL OBJECTIVES

Section overview

Financial objectives and corporate strategy The primary corporate objective Wealth maximisation Maximising profits Growth in earnings per share Measuring the achievement of financial objectives

Financial objectives: conclusion

Other objectives

Role of the financial manager: Three decisions

2.1 Financial objectives and corporate strategy

Every organisation exists for a purpose. For example, an organisation might exist to manufacture electronic equipment, manufacture chemicals, provide a transport service or provide an education to children.

Within this overall purpose, an organisation should have a primary objective.

the main objective of a company might be to maximise the wealth of the company’s owners, its equity shareholders;

the main objective of a state-owned organisation might be stated in terms of providing a certain standard of public service;

the main objective of a charity would be to fulfil its charitable purpose (for example, provide maximum aid or support for a particular group of people).

When the main objective of an organisation is not a financial objective, there is always a financial constraint on its objective, such as providing the highest quality of public service with the available finance.

The identification of a primary objective is a starting point for the formulation of a strategy to achieve that objective.

The process can be shown as follows:

Illustration: Strategic process

Step 1: Identify corporate objective (usually a financial objective) Step 2: Establish targets for the financial objectiv

Step 3: Develop business strategies for achieving the financial objective/targets

Step 4: Convert strategies into action plans Step 5: Monitor performance



2.2 The primary corporate objective

For companies, the primary corporate objective is often stated as maximising the wealth of its owners (equity shareholders). This means maximising the market value of the company.

Many of financial management models covered later in this text test a proposed course of action in terms of its impact on the value of the company;

The objective is not just a theoretical one. In practice, surveys have shown that most chief executives view increasing the market value of the company which they control as their main responsibility.

The primary objective is directed to the benefit of a single stakeholder group (the owners). In reality, the wealth maximisation objective must be pursued within the boundaries of the needs of other stakeholders. For example, cocaine smuggling or money laundering might lead to large positive cash flows for a company but one of the company’s stakeholders (the government) prohibits these activities.

Corporate social responsibility (CSR)

Corporate social responsibility is a term to describe the view that a company should pursue objectives that are in the interests of stakeholder groups other than shareholders, such as employees and society as a whole (the ‘public’). This is discussed in more detail later in this chapter.

2.3 Wealth maximisation

The main corporate objective is the maximisation of shareholder wealth and this is taken as maximising the market value of the company.

Shareholder wealth is increased by dividend payments and a higher share price. Corporate strategies are therefore desirable if they result in higher dividends, a higher share price, or both.

There are practical problems with using this objective:

What should be the time period for setting targets for wealth maximisation?

How will wealth creation be measured, and how can targets be divided into targets for dividend payments and targets for share price growth?

Share prices are often affected by general stock market sentiment, and short-term increases or falls in a share price might be caused by investor attitudes rather than any real success or failing of the company itself.

The objective of maximising shareholder wealth is generally accepted as a sound basis for financial planning, but is not practical in terms of actually setting financial performance targets and measuring actual performance against the target. Other financial objectives might therefore be used instead, in the expectation that if these objectives are achieved, shareholder wealth will be increased by an optimal amount.

These include:

maximising profits; and

achieving growth in earnings per share.



2.4 Maximising profits

A company might express its main financial objectives in terms of profit maximisation, and targets can be set for profit growth over a strategic planning period.

Profit growth objectives have the advantage of simplicity. When a company states that its aim is to increase profits by 20% per year for the next three years, the intention is quite clear and easily understood – by managers, investors and others.

The main problem with an objective of maximising profits is to decide the time period over which profit performance should be measured.

Short-term profits might be increased only by taking action that will have a harmful effect on profits in the longer term. For example, a company might avoid replacing ageing equipment in order to avoid higher depreciation and interest charges, or might avoid investing in new projects if they will make losses initially – regardless of how profitable they might be in the longer term.

It is often necessary to invest now to improve profits over the longer term. Innovation and taking business risks are often essential for long-term success. However, longer-term success is usually only achieved by making some sacrifices in the short term.

In practice, managers often focus on short-term profitability, and give insufficient thought to the longer term:

Partly because much of their remuneration might depend on meeting annual performance targets. Annual cash bonuses, for example, might be dependent on making a minimum amount of profit for the year.

Partly because managers often do not expect to remain in the same job for more than a few years; therefore short-term achievements might mean more to them than longer-term benefits after they have moved on to a different position or job.

Another problem with an objective of profit maximisation is that profits can be increased by raising and investing more capital. When share capital is increased, total profits might increase due to the bigger investment, but the profit per share might fall. This is why a company’s financial objective might be expressed in terms of profit per share or growth in profit per share.

2.5 Growth in earnings per share

The most common measure of profit per share is earnings per share or EPS. A financial objective might be to increase the earnings per share each year, and possibly to grow EPS by a target amount each year for the next few years. If there is growth in EPS, there will be more profits to pay out in dividends per share, or there will be more retained profits to reinvest with the intention of increasing earnings per share even more in the future. EPS growth should therefore result in growth in shareholder wealth over the long term.

However, there are some problems with using EPS growth as a financial objective. It might be possible to increase EPS through borrowing and debt capital. If a company needs more capital to expand its operations, it can raise the money by borrowing. Tax relief is available on the interest charges, and this reduces the effective cost of borrowing. Shareholders benefit from any growth in profits after interest, allowing for tax relief on the interest, and EPS increases.



However, higher financial gearing (the ratio of debt capital to total capital) can expose shareholders to greater financial risk. As a consequence of higher gearing, the share price might fall even when EPS increases.

2.6 Measuring the achievement of financial objectives

When a financial objective is established, actual performance should be measured against the objective.

This requires the calculation of one or more suitable performance measurements.

Financial objectives are commonly measured using ratio analysis. Financial ratios can be used to make comparisons. These might be:

Comparisons over a number of years. By looking at the ratios of a company over a number of years, it might be possible to detect improvements or a deterioration in the financial performance or financial position of the entity. Ratios can therefore be used to make comparisons over time, and to identify changes or trends

Comparisons with the similar ratios of other, similar companies for the same period.

Comparisons with ‘industry average’ ratios.

Return on capital employed (ROCE)

Profit-making companies should try to make a profit that is large enough in relation to the amount of money or capital invested in the business. The most important profitability ratio is return on capital employed or ROCE. For a single company:

Formula:

ROCE =

Profit before interest and taxation X 100%

(Share capital and reserves + long-term debt capital + preference share capital)

The capital employed is the share capital and reserves, plus long-term debt capital such as bank loans, bonds and loan stock.

Where possible, use the average capital employed during the year. This is usually the average of the capital employed at the beginning of the year and end of the year.



Example: Return on capital employed

The following figures relate to Company X for Year 1.

1 January Year 1

31 December Year 1

₦ ₦ Share capital (₦1 shares) 200,000 200,000 Share premium 100,000 100,000 Retained earnings 500,000 600,000 Bank loans 200,000 500,000

1,000,000 1,400,000 ₦

Profit before tax 210,000 Income tax expense (65,000)

Profit after tax 145,000

Interest charges on bank loans were ₦30,000.

ROCE is calculated as follows:

ROCE = 240,000 (W1)/1,200,000 (W2) 100 = 20%

W1 Profit before interest and tax ₦ Profit before tax 210,000 Add back interest deducted 30,000

Profit before interest and tax 240,000

W2 Capital employed ₦ Capital employed at the beginning of the year 1,000,000 Capital employed at the end of the year 1,400,000

2,400,000 ÷2 Average capital employed 1,200,000

This ROCE figure can be compared with the ROCE achieved by the company in previous years, and with the ROCE achieved by other companies, particularly competitors.



Return on shareholder capital

Return on shareholder capital (ROSC) measures the return on investment that the shareholders of the company have made. This ratio normally uses the values of the shareholders’ investment as shown in the statement of financial position (rather than market values of the shares).

Formula: Return on shareholder capital

ROSC =

Profit after taxation and preference dividend 100

Share capital and reserves

The average value of shareholder capital should be used if possible. This is the average of the shareholder capital at the beginning and the end of the year.

Profit after tax is used as the most suitable measure of return for the shareholders, since this is a measure of earnings (available for payment as dividends or for reinvestment in the business).

Example: Return on shareholder capital

The following figures relate to Company X for Year 1.

1 January Year 1

31 December Year 1

₦ ₦ Share capital (₦1 shares) 200,000 200,000 Share premium 100,000 100,000 Retained earnings 500,000 600,000

Shareholder capital 800,000 900,000 Bank loans 200,000 500,000

1,000,000 1,400,000 ₦

Profit before tax 210,000 Income tax expense (65,000)

Profit after tax 145,000

Interest charges on bank loans were ₦30,000.

ROSC is calculated as follows:

ROSC = 145,000/850,000 (W2) 100 = 17.06%

W1 Shareholder capital ₦ Shareholder capital at the beginning of the year 800,000 Shareholder capital at the end of the year 900,000

1,700,000 ÷2

Average shareholder capital 850,000



Note that the return on shareholder’s capital is not directly comparable with ROCE because ROCE is a before-tax measure of return whereas return on equity is measured after tax.

Earnings per share and dividend per share

Formula: Basic EPS

Net profit (or loss) attributable to ordinary shareholders during a period weighted average number of shares in issue during the period

The earnings per share (EPS) is a measure of the profit after taxation (and preference share dividend, if any) per equity share, during the course of a financial year. The EPS might be:

a historical EPS, as reported in the company’s financial statements, or

a forward-looking EPS, which is the EPS that the company will expect to achieve in the future, usually in the next financial year.

Dividend per share may be important for shareholders who are seeking income from shares rather than capital growth. The company may have a dividend policy which aims for steady growth of dividend per share.

Example: Earnings per share

Using the figures in the previous example:

EPS = profit after tax/Number of ordinary shares = ₦145,000/200,000 = 0.725 per share

Changes in share price and dividend

Financial performance can also be measured by the return provided to shareholders over a period of time such as a financial year. The total return consists of dividend payments plus the increase in the share price during the period (or minus the fall in the share price).

This total return, often called the Total Shareholder Return or TSR, can be expressed as a percentage of the value of the shares at the beginning of the period.

Example: Total Shareholder Return

At 1 January the market value of a company’s shares was ₦840 per share.

During the year dividends of ₦45 per share were paid and at 31 December the share price was ₦900.

The share price has risen by ₦60; therefore TSR = ₦(60 + 45)/₦840 = 0.125 or 12.5%.



2.7 Financial objectives: conclusion

It is generally accepted that the main financial objective of a company should be to maximise (or at least increase) shareholder wealth.

There are practical difficulties in selecting a suitable measurement for growth in shareholder wealth. Financial targets such as profit maximisation and growth in EPS might be used, but no financial target on its own is ideal.

Financial performance is therefore assessed in a variety of ways: by the actual or expected increase in the share price, growth in profits, growth in EPS, and so on.

In practice, companies might have other stated objectives but these can usually be justified in terms of the pursuit of wealth maximisation.

Stated objective Link to wealth maximisation To maximise profits This would lead to the ability to pay out bigger

dividends and to the ability to take advantage of favourable investment opportunities. This should lead to increased market value

To increase earnings per share year on year.

This would lead to a positive perception in the market place which in turn should lead to a higher demand for the shares thus increasing market value.

2.8 Other objectives

Companies might have other stated non-financial objectives but these can also be justified in terms of the pursuit of wealth maximisation.

Stated objective Link to wealth maximisation To pay staff competitive salaries

This should lead to happy and competent staff who will work hard for the company thus enabling it to achieve good performance. This should lead to increased market value

To invest in staff training

This should lead to staff with higher skills leading to improved performance. This should lead to increased market value

To invest in new product development

This would lead to bigger profits in the future (if successful). This should lead to increased market value

To take into account the needs of society and the need to preserve the environment

If the company was seen to do otherwise it would lead to bad publicity which would be reflected in the share price falling.



2.9 Role of the financial manager: Three decisions

A large part of the role of the senior financial manager is advisory, providing advice on financial strategy and policies.

In order to achieve its corporate objectives, a company must develop strategies. To achieve an objective of maximising shareholder wealth, financial strategies should be formulated by the board of directors. Financial strategy is often (but not always) targeted towards achieving growth in annual earnings and achieving a return on investment in excess of the cost of the funds used to make the investment.

Financial managers provide advice concerned with three fundamental decisions:

Investment decisions – Which investments should be undertaken using capital resources

Financing decisions – How finance should be raised in order to minimise cost of capital

Dividend decisions – What the balance should be between the amount of profit distributed and that held back for reinvestment in the business.

Further responsibilities would include advice on:

communicating financial policy to internal and external stakeholders

financial planning and control

management of risk.

These are covered in more detail later in this text.



3 THE TREASURY FUNCTION

Section overview

Role of the treasury function Cash flow forecasting and cash management Financing long-term and short-term investments Financial risk management

Possible risks of operating a treasury department

Treasury department as a profit centre

3.1 Role of the treasury function

Cash management in a large organisation is often handled by a specialist department, known as the treasury department.

The central treasury department is responsible for making sure that cash is available in the right amounts, at the right time and in the right place. To do this, it must:

produce regular cash flow forecasts to predict surpluses and shortfalls;

arrange short-term borrowing and investment when necessary;

deal with the entity’s banks;

finance the business on a day-to-day basis, for example by arranging facilities with a bank;

advise senior management on long-term financing requirements;

arrange to purchase foreign currency when needed, and arrange to sell foreign currency cash receipts;

protect the business against the risk of adverse movements in foreign exchange rates, when the business has receipts and payments, or loans and investments.

Some of these are discussed in more detail below.

3.2 Cash flow forecasting and cash management

A role of the treasury department is to centralise the control of cash, to make sure that:

cash is used as efficiently as possible;

surpluses in one part of the business (for example, in one profit centre) are used to fund shortfalls elsewhere in the business, and

surpluses are suitably invested and mature when the cash is needed.

Cash flow forecasting

Cash flow forecasting is an important aspect of treasury management. A company must have enough cash (or access to borrowing, such as a bank overdraft facility) to meet its payment obligations. Cash forecasts are therefore made and revised regularly, to establish whether the organisation expects to have a cash surplus or to be short of cash.



If a cash deficit is forecast, measures should be taken to ensure that cash will be available. It might be necessary to ask a bank for more finance. Some expenditure might be deferred. Alternatively, measures might be taken to speed up receipts from customers.

If a cash surplus is forecast, the treasury department will consider how the surplus funds should be used. For example, if the surplus is expected to be temporary, how long will the surplus last and what is the most profitable method of investing the money (without risk) for that period?

Short-term cash forecasts can be prepared using receipts and payments cash budgets. Longer-term cash forecasts can be made by preparing an expected cash flow statement for the forecast period.

Larger businesses find it much easier than smaller businesses to raise cash when they are expecting a cash shortfall. Similarly, when they have a cash surplus, they find it easier to invest the cash.

Cash management

A centralised treasury department is able to manage the cash position of the group as a whole. It can manage total cash receipts, total cash payments and total net cash balances.

One technique for doing this is to pool bank accounts. All the bank accounts throughout the group for a particular currency might be pooled. At the end of each day, the balances in each account are transferred to a centralised cash account. (The cash is ‘pooled’). The cash deficits in some accounts and cash surpluses in other accounts are therefore netted. In this way, the company can avoid interest charges on accounts that are in deficit, and transfer cash between accounts as required.

Pooling and netting of cash flows therefore improves cash management. However, for pooling and netting to be effective, the cash has to be managed by a central treasury department.

Advantages

Making the management of cash the responsibility of a centralised treasury department has significant advantages.

Cash is managed by specialist staff – improving cash management efficiency.

All the cash surpluses and deficits from different bank accounts used by the entity can be ‘pooled’ together into a central bank account. This means that cash can be channelled to where it is needed, and overdraft interest charges can be minimised.

Central control over cash lowers the total amount of cash that needs to be kept for precautionary reasons. If individual units had to hold their own ‘safety stock’ of cash, then the total amount of surplus cash would be higher (when added together) than if cash management is handled by one department.

Putting all the cash resources into one place increases the negotiating power of the treasury department to get the best deals from the banks.



3.3 Financing long-term and short-term investments

A company must be able to finance its planned long-term and short-term investments (including any proposed takeovers). Preference share capital is rare, and the options available to companies are therefore as follows:

For long-term investments, there should be long-term finance. Long-term finance is either equity or debt. Bank loans might be classified as long-term debt, provided that it is a fixed loan or a revolving credit facility for several years. However, bank loans are typically for up to about seven years

Short-term investments might be defined as working capital assets. Inventory and receivables should normally be financed by a combination of long-term finance and short-term liabilities (such as trade payables).

Sources of equity

For many companies, the main source of new equity finance is retained profits. Profits are retained and reinvested to finance new investments and further growth.

Occasionally, a company might wish to raise extra capital by issuing new shares for cash. However, it is difficult for a small company to raise new finance in this way if its shares are not traded on a stock market and it has only a small number of individual shareholders.

A company whose shares are traded on the stock market might wish to issue new shares for cash. In some countries (such as the UK), it is a legal requirement for companies issuing new shares for cash to offer the shares to the existing shareholders in proportion to their existing shareholding. (The shareholders might agree to waive this right in certain circumstances and within certain limits).

A company will only be able to issue new shares for cash in this way if it has the confidence and support of its shareholders and other institutions in the stock market.

In a takeover bid, the shareholders in the target company might be offered new shares in the bidding company as the purchase consideration.

In some cases, a company whose shares are not traded on the stock market might be able to raise new capital by issuing shares, when the new equity finance is provided by specialist ‘venture capital’ organisations.

Sources of debt

For most companies, the main source of debt capital is their bank or banks. Large companies, however, are able to raise debt capital by issuing bonds in the bond markets.

Sources of short-term finance

Companies obtain short-term finance mainly from trade credit and bank lending. Large companies might have access to other sources of short-term borrowing, such as:

commercial paper programmes (CP), or

bankers’ acceptance facilities (BA acceptances).



Trade finance

When the company needs finance to support its foreign trade, the treasury function might be responsible for arranging the financing.

3.4 Financial risk management

The treasury department is usually responsible for the management of financial risk. The main financial risks facing companies are:

foreign exchange risk or currency risk;

interest rate risk;

credit risk;

market risk, where companies hold large quantities of market securities (such as shares and bonds) as assets. Market risk is the risk of an adverse movement in the market price of these assets.

Foreign exchange risk and interest rate risk are described in later chapters.

Credit risk

Credit risk is the risk that a debt will not be paid and will become a bad debt, or that a customer will make debt payments later than scheduled. Credit control and credit risk management are aspects of day-to-day financial management, and you should already be familiar with credit management and debt collection systems.

Companies that borrow from banks are a credit risk to the bank, and a function of the treasury department in large companies might be to monitor the perceived credit risk of the company. Large companies might have a formal credit rating from one of the credit rating agencies (such as Moody’s and Standard & Poor’s). The cost of borrowing for these companies depends on their credit rating.

Banks will charge a higher ‘spread’ over the risk-free rate on loans to companies with a lower credit rating.

If a company wants to issue new bonds, the interest payable on the bonds will depend on the credit rating attached to them.

The treasury management of a company that has debt with a credit rating might therefore be required to monitor the rating and maintain a dialogue with the credit rating agencies.

The link between credit ratings spreads over the risk-free rate and the cost of borrowing is explained in a later chapter.



3.5 Possible risks of operating a treasury department

The main risks in treasury operations, for a large Treasury department, may be as follows.

There is a risk that the treasury department will raise finance for the entity in an inefficient or inappropriate way. For example, interest rates on borrowing may be higher than necessary. There may be too much short-term borrowing and not enough longer-term borrowing (or not enough short-term borrowing and too much long-term borrowing). The balance between equity finance and debt may be inappropriate, resulting in a high cost of capital for the entity.

The treasury department may fail to manage the financial risks of the entity sufficiently. For example, it might make insufficient use of forward contracts (for foreign exchange) and may fail to manage interest rate risk using derivatives such as swaps.

The treasury department may employ ‘dealers’ for foreign exchange or investing surplus funds. Dealers may exceed their trading limits. They may make mistakes when dealing, such as buying when they ought to sell, or making a mistake when agreeing the price or the quantity for a transaction. Dealers may also fail to record/document their transactions properly.

The treasury department may earn only a low return on their investment of surplus funds.

3.6 Treasury department as a profit centre

A treasury department might be run as a cost centre or as a profit centre. The aim of establishing a treasury department as a profit centre is to motivate management (both in treasury and in its customers in the other parts of the organisation) to deal on a market priced basis.

Advantages of running treasury department as a profit centre

potential for additional profits;

the department is motivated to operate efficiently; and

transfer costs to the business units would be realistic as they should be at the market value of services received.

Disadvantages of running treasury department as a profit centre

potential for huge losses due to speculative deals;

additional administrative costs in running a profit centre; and

the additional cost of management time in terms of negotiating transfer prices.



4 STAKEHOLDERS

Section overview

Stakeholders and their objectives Conflicts between different stakeholder objectives Agency theory Incentive schemes (management reward schemes

4.1 Stakeholders and their objectives

Although the theoretical objective of a private sector company might be to maximise the wealth of its owners, other individuals and groups have an interest in what a company does and they might be able to influence its corporate objectives. Anyone with an interest in the activities or performance of a company are ‘stakeholders’ because they have a stake or interest in what happens.

It is usual to group stakeholders into categories, with each category having its own interests and concerns. The main categories of stakeholder group in a company are usually the following.

Shareholders. The shareholders themselves are a stakeholder group. Their interest is to obtain a suitable return from their investment and to ‘maximise their wealth’. However there might be different types of shareholder in a company: some shareholders are long-term investors who have an interest in longer-term share price growth as well as short-term dividends and gains. Other shareholders might be short-term investors, hoping for a quick capital gain and /or high short-term profits and dividends.

Directors and senior managers. An organisation is led by its board of directors and senior executive management. These are individuals whose careers, income and personal wealth might depend on the company they work for.

Other employees. Similarly other employees in a company have a personal interest in what the company does. They receive their salary or wages from the company, and the company might also offer them job security or career prospects. However, unlike directors and senior executives, other employees might have less influence on what the company does, unless they have strong trade union representation or have some other source of ‘power’ and influence, such as specialist skills that the company needs and relies on.

Lenders. When a company borrows money, the lender or lenders are stakeholders. Lenders might be banks or investors in the company’s bonds. The main concern for lenders is to protect their investment. If the company is heavily in debt, credit risk might be a problem, and lenders might be concerned about the ability of the company to meet its interest and principal repayment obligations. They might also want to ensure that the company does not continue to borrow even more money, so that the credit risk increases further.

The government. The government also has an interest in companies, especially large companies, for a variety of reasons.

The government regulates commercial and industrial activity; therefore it has an interest in companies as a regulator.



Companies are an important source of taxation income for the government, both from tax on corporate profits but also from tax on employment income and sales taxes.

Companies are also employers, and one of the economic aims of government might be to achieve full employment.

Some companies are major suppliers to the government.

Customers. Customers have an interest in the actions of companies whose goods or services they buy, and might be able to influence what companies do.

Suppliers. Similarly major suppliers to a company might have some influence over its actions.

Society as a whole. A company might need to consider the concerns of society as a whole, about issues such as business ethics, human rights, the protection of the environment, the preservation of natural resources and avoiding pollution. Companies might need to consider how to protect their ‘reputation’ in the mind of the public, since a poor reputation might lead to public pressure for new legislation, or a loss in consumer (customer) support for the company’s products or services.

Companies might therefore state their objectives in terms of seeking to increase the wealth of their shareholders, but subject to a need to satisfy other stakeholders too - rewarding employees well and being a good employer, acting ethically in business, and showing due concern for social and environmental issues.

The ability of stakeholders to influence what a company does will depend to a large extent on:

the extent to which their interests can be accommodated and do not conflict with each other

the power of each group of stakeholders to determine or influence the company’s objectives and strategies.

4.2 Conflicts between different stakeholder objectives

Different stakeholders have differing interests in a company, and these might be incompatible and in conflict with each other. When stakeholders have conflicting interests:

either a compromise will be found so that the interests of each stakeholder group are satisfied partially but not in full

or the company will act in the interests of the most powerful stakeholder group, so that the interests of the other stakeholder groups are ignored.

In practice there might be a combination of these two possible outcomes. A company might make small concessions to some stakeholder groups but act mainly in the interests of its most powerful stakeholder group (or groups).

Some examples of conflicting interests of stakeholder groups are as follows.

If a company needs to raise more long-term finance, its directors and shareholders might wish to do so by raising more debt capital, because debt capital is usually cheaper than equity finance. (The reason why this is so will be explained in a later chapter.) However, existing lenders might believe that the company should not borrow any more without first



increasing its equity capital – by issuing more shares or retaining more profits. The terms of loan agreements (the lending ‘covenants’) might therefore include a specification that the company must not allow its debt level (gearing level) to exceed a specified maximum amount.

The government might want to receive tax on a company’s profits, whereas the company will want to minimise its tax liabilities, through ‘efficient’ tax avoidance schemes.

A company cannot maximise returns to its shareholders if it also seeks to maintain a contented work force, possibly by paying them high wages and salaries.

A company cannot maximise short-term profits if it spends money on environmental protection measures and safe waste disposal measures.

However the most significant conflict of interest between stakeholders in a large company, especially a public company whose shares are traded on a stock market, is generally considered to be the conflict of interests between:

the shareholders and

the board of directors, especially the executive directors, and the other senior executive managers.

This perceived conflict of interests is fundamental to agency theory and the concepts of good corporate governance that have developed from agency theory.

4.3 Agency theory

Agency theory was developed by Jensen and Meckling (1976) who defined the agency relationship as a form of contract between a company’s owners and its managers, where the owners appoint an agent (the managers) to manage the company on their behalf. As a part of this arrangement, the owners must delegate decision-making authority to the management.

The owners expect the agents to act in the best interests of the owners. Ideally, the ‘contract’ between the owners and the managers should ensure that the managers always act in the best interests of the shareholders. However, it is impossible to arrange the ‘perfect contract’, because decisions by the managers (agents) affect their own personal interests as well as the interests of the owners. Managers will give priority to their personal interests over those of the shareholders.

When this happens, there is a weakness or failing on the governance of the company.

Agency conflicts

Agency conflicts are differences in the interests of a company’s owners and managers. They arise in several ways.

Moral hazard. A manager has an interest in receiving benefits from his or her position as a manager. These include all the benefits that come from status, such as a company car, use of a company airplane, lunches, attendance at sponsored sporting events, and so on. Jensen and Meckling suggested that a manger’s incentive to obtain these benefits is higher when he has no shares, or only a few shares, in the company. The biggest problem is in large companies.



Effort level. Managers may work less hard than they would if they were the owners of the company. The effect of this ‘lack of effort’ could be lower profits and a lower share price. The problem will exist in a large company at middle levels of management as well as at senior management level. The interests of middle managers and the interests of senior managers might well be different, especially if senior management are given pay incentives to achieve higher profits, but the middle managers are not.

Earnings retention. The remuneration of directors and senior managers is often related to the size of the company, rather than its profits. This gives managers an incentive to grow the company, and increase its sales turnover and assets, rather than to increase the returns to the company’s shareholders. Management are more likely to want to re-invest profits in order to make the company bigger, rather than payout the profits as dividends.

Risk aversion. Executive directors and senior managers usually earn most of their income from the company they work for. They are therefore interested in the stability of the company, because this will protect their job and their future income. This means that management might be risk-averse, and reluctant to invest in higher-risk projects. In contrast, shareholders might want a company to take bigger risks, if the expected returns are sufficiently high.

Time horizon. Shareholders are concerned about the long-term financial prospects of their company, because the value of their shares depends on expectations for the long-term future. In contrast, managers might only be interested in the short-term. This is partly because they might receive annual bonuses based on short-term performance, and partly because they might not expect to be with the company for more than a few years. Managers might therefore have an incentive to increase accounting return on capital employed (or return on investment), whereas shareholders have a greater interest in long-term share value.

Agency costs

Agency costs are the costs that the shareholders incur when professional managers to run their company.

Agency costs do not exist when the owners and the managers are exactly the same individuals.

Agency costs start to arise as soon as some of the shareholders are not also directors of the company.

Agency costs are potentially very high in large companies, where there are many different shareholders and a large professional management.

There are three aspects to agency costs:

They include the costs of monitoring. A company establishes systems for monitoring the actions and performance of management, to try to ensure that management are acting in their best interests. An important example of monitoring is the requirement for the directors to present an annual report and audited accounts to the shareholders, setting out the financial performance and financial position of the company. Preparing accounts and having them audited has a cost.

Agency costs also include the costs to the shareholder that arise when the managers take decisions that are not in the best interests of the



shareholders (but are in the interests of the managers themselves). For example, agency costs arise when a company’s directors decide to acquire a new subsidiary, and pay more for the acquisition than it is worth. The managers would gain personally from the enhanced status of managing a larger group of companies. The cost to the shareholders comes from the fall in share price that would result from paying too much for the acquisition.

The third aspect of agency costs is costs that might be incurred to provide incentives to managers to act in the best interests of the shareholders. These are sometimes called bonding costs. The main example of bonding costs are the costs of remuneration packages for senior executives. These costs are intended to reduce the size of the agency problem. Directors and other senior managers might be given incentives in the form of free shares in the company, or share options. In addition, directors and senior managers might be paid cash bonuses if the company achieves certain specified financial targets.

Reducing the agency problem

Jensen and Meckling argued that in order to reduce the agency problem, incentives should be provided to management to increase their willingness to take ‘value-maximising decisions’ – in other words, to take decisions that benefit the shareholders by maximising the value of their shares.

Several methods of reducing the agency problem have been suggested. These include:

Devising a remuneration package for executive directors and senior managers that gives them an incentive to act in the best interests of the shareholders.

Fama and Jensen (1983) argued that an effective board must consist largely of independent non-executive directors. Independent non-executive directors have no executive role in the company and are not full-time employees. They are able to act in the best interests of the shareholders.

Independent non-executive directors should also take the decisions where there is (or could be) a conflict of interest between executive directors and the best interests of the company. For example, non-executive directors should be responsible for the remuneration packages for executive directors and other senior managers.

These ideas for reducing the agency problem are contained in codes of corporate governance.



4.4 Incentive schemes (management reward schemes)

This chapter has so far made the point that the main objective of a company should be a financial objective, but there are different ways of stating this objective and in measuring the extent to which the objective has been achieved.

There are different stakeholder groups with an interest in a company, and these are likely to have conflicting interests. The main conflict of interests is the agency problem and the different interests of shareholders and senior executive managers and directors.

This raises the question: Can the agency problem be reduced and can managers be persuaded to focus on returns to shareholders as the main objective of the company? Managers may be encouraged to work in the best interests of the company if there are remuneration incentive schemes (reward schemes) linked to profits, earnings, share price or Total Shareholder Return.

Most, if not all, large stock market companies have remuneration schemes for their executive directors and other senior managers, and the purpose of such schemes is to make the personal interests of the directors and managers similar to those of the shareholders. By achieving a financial performance that is in the interests of the shareholders, directors and managers will also obtain personal benefits for themselves.

Structure of a remuneration package for senior executives

The structure of a remuneration package for executive directors or senior managers can vary, but it is usual for a remuneration package to have at least three elements.

A basic salary (with pension entitlements). Basic salaries need to be high enough to attract and retain individuals with the required skills and talent.

Annual performance incentives, where the reward is based on achieving or exceeding specified annual performance targets. The performance target might be stated as profit or earnings growth, EPS growth, achieving a profit target or achieving a target for TSR. Some managers might also have a non-financial performance target. Some managers might have several annual performance targets, and there is a reward for achieving each separate target. Annual rewards are usually in the form of a cash bonus.

Long-term performance incentives, which are linked in some way to share price growth or TSR over a longer period of time (in practice typically three years). Long-term incentives are usually provided in the form of share awards or share options in the company. The purpose of these awards is to give the manager a personal incentive in trying to increase the value of the company’s shares. As a holder of shares or share options, the manager will benefit financially from a rising share price.

Share awards

With a share award scheme, the company purchases a quantity of its own shares and awards these to its executive directors and other senior managers on condition that certain ‘long-term’ financial targets are achieved, typically over a three-year period.

Share options

A company might award share options to its executives. A share option gives its holder the right to purchase new shares in the company on or after a specified



date in the future, typically from three years after the options have been awarded. The right to buy new shares in the company is at a fixed price (an ‘exercise price’) that is specified when the share options are awarded. Typically the exercise price is the market price of the shares at the time the options are awarded. The holder of a share option gains from any increase in the share price above the exercise price, and so has a direct personal interest in a rising share price.

For example, a company might award share options to its chief executive officer. If the market price of the shares at the date of the award is, say, ₦7.00, the CEO might be given 500,000 share options at ₦7 per share, exercisable from three years after the date of the option award. If the share price three years later is, say, ₦10, the CEO will be able to buy 500,000 new shares at ₦7 and sell them immediately at ₦10, to make a personal financial gain of ₦1,500,000.



5 CORPORATE SOCIAL RESPONSIBILITY

Section overview

Definition of corporate social responsibility (CSR) Principles of CSR CSR and stakeholders in the company The effect of CSR on company strategy

5.1 Definition of corporate social responsibility (CSR)

Corporate social responsibility refers to the responsibilities that a company has towards society. CSR can be described decision-making by a business that is linked to ethical values and respect for individuals, society and the environment, as well as compliance with legal requirements.

CSR is based on the concept that a company is a citizen of the society in which it exists and operates.

As a corporate citizen of society, it owes the same sort of responsibilities to society at large that other citizens should owe.

There is a social contract between a company and the society in which it operates. As the owner or user of large amounts of property and other resources, companies as corporate citizens also owe a duty to society to use its property and resources in a responsible way. In return, society allows the company to operate and remain in existence.

Corporate Social Responsibility is related to the idea that as well as their responsibilities to shareholders, boards of companies are also responsible to the general public and other stakeholder groups.

There are two key areas of responsibility:

General responsibilities that are a key part of the board’s duties which need to be completed in order to succeed in their industry and/or are regulatory/legal requirements that are imposed on them; and

Duties that are seen by some people feel go beyond these general responsibilities.

5.2 Principles of CSR

Corporate social responsibility has five main aspects. For any company, some of these aspects might be more significant than others.

A company should operate in an ethical way, and with integrity. A company should have a recognised code of ethical behaviour and should expect everyone in the company to act in accordance with the ethical guidelines in that code.

A company should treat its employees fairly and with respect. The fair treatment of employees can be assessed by the company’s employment policies, such as providing good working conditions and providing education and training to employees.

A company should demonstrate respect for basic human rights. For example, it should not tolerate child labour.



A company should be a responsible citizen in its community. Responsibility to the community might be shown in the form of investing in local communities, such as local schools or hospitals. This can be an important aspect of CSR for companies that operate in under-developed countries or regions of the world.

A company should do what it can to sustain the environment for future generations. This could take the form of:

reducing pollution of the air, land or rivers and seas

developing a sustainable business, whereby all the resources used by the company are replaced

cutting down the use of non-renewable (and polluting) energy resources such as oil and coal and increasing the use of renewable energy sources (water, wind)

re-cycling of waste materials.

5.3 CSR and stakeholders in the company

The concept of corporate citizenship and corporate social responsibility is consistent with a stakeholder view of how a company should be governed. A company has responsibilities not only to its shareholders, but also to its employees, all its customers and suppliers, and to society as a whole.

In developing strategies for the future, a company should recognise these responsibilities. The objective of profit maximisation without regard for social and environmental responsibilities should not be acceptable.

Example: CSR

When a company promotes itself as a company with strong ethical views and a considered policy on CSR, it exposes itself to reputation risk. This is the risk that its reputation with the general public and customers will be damaged by an unexpected event or disclosure.

For example, an ethical company might find that one or more of its major suppliers, based in a foreign country, is using forced labour or child labour in the production of goods that the company buys.

5.4 The effect of CSR on company strategy

The awareness of CSR will vary between different countries. To remain successful in business, companies must respond to changes in the expectations of its customers. In many countries, there has been a significant increase in public awareness of environmental problems, such as global warming (pollution and energy consumption) and the potential for natural disasters that this creates. There is also concern about the irreplaceable loss of many natural resources and the failure to re-cycle many raw materials that could be used again in products or services.

If companies fail to respond to growing public concern about social and environmental issues, they will suffer a damage to their reputation and the possible loss (long term) of sales and profits. This is the problem for companies of reputation risk. Unfortunately, although there is genuine concern by some companies for CSR issues, other companies express concerns about CSR issues in order to improve



their public relations image with the public, and as a way of marketing their products.



6 CHAPTER REVIEW

Chapter review

Before moving on to the next chapter check that you now know how to: Explain the meaning of financial strategy and strategic financial management.

Explain the formulation of corporate objectives and identify the primary corporate objective

Explain how other objectives (both financial and non-financial) link to the primary corporate objective

Explain the treasury function

Define and list stakeholders and identify their interest in an organisation

Define corporate social responsibility and explain how it links corporate objectives to stakeholder requirements



C H

A P

T E

R

2 Regulatory background

Contents 1 Money laundering

2 Duties of directors

3 Nigerian stock exchange

4 Chapter review



INTRODUCTION

Purpose

Strategic financial management supports management in making informed decisions. Candidates are expected to apply relevant knowledge in recommending appropriate options for financing a business, recognising and managing financial risks and investments. Professional accountants need a strong background in accounting, economics, law, mathematics and behavioural sciences.

Competencies

A Financial environment and role of financial managers (f) Report on the professional, regulatory and legal framework relevant to

financial management including: Stock exchange requirements, money laundering, directors’ responsibilities.

Exam context

This chapter explains certain aspects of the regulatory and legal framework relevant to financial management in Nigeria.

By the end of this chapter you will be able to:

Define money laundering

Explain the main legal rules enacted in Nigeria to combat money laundering

Explain directors’ responsibilities under Nigerian law

Explain in overview the regulatory role of the Securities Exchange Commission

Explain in overview the role of Nigerian Stock Exchange

Chapter 2: Regulatory background


1 MONEY LAUNDERING

Section overview

Introduction Financial Action Task Force against Money Laundering Nigeria Specific rules on cash transfers Specific rules with regard to financial institutions and designated non-financial

institutions Rules specific to designated non- financial institutions Rules specific to financial institutions

1.1 Introduction

Money laundering is an international problem which is addressed on an international level by mutual co-operation between countries and international bodies.

Money laundering covers any activity by which the apparent source and ownership of money or property representing the proceeds of crime are changed, so that they appear to have been obtained legitimately.

The methods by which money may be laundered are varied and can range in sophistication from simple to complex.

Money laundering often occurs in three steps:

Cash is introduced into the financial system by some means (“placement”); then

Complex financial transactions camouflage the illegal source (“layering”); then

Wealth appears to have been generated from legal sources (“integration”).

Money laundering takes several different forms although most methods can be categorized into one of a few types including:

Structuring (smurfing): A method of placement by which cash is deposited with banks in smaller amounts in order to avoid suspicion.

Bulk cash smuggling to jurisdictions with greater bank secrecy or less rigorous money laundering enforcement.

Cash-intensive businesses that simply deposit both legitimate and criminally derived cash as legitimate earnings.

Real estate may be purchased with illegal proceeds, and then sold. The proceeds from the sale appear to outsiders to be legitimate income



1.2 Financial Action Task Force against Money Laundering

Formed in 1989 by the G7 countries, the Financial Action Task Force on Money Laundering (FATF) is an inter-governmental body whose purpose is to develop and promote an international response to combat money laundering and combat the financing of terrorism.

FATF is a policy-making body, which brings together legal, financial and law enforcement experts to achieve national legislation and regulatory reforms.

FATF recommendations

Countries should criminalise money laundering on the basis of the United Nations Conventions.

Countries should ensure that financial institution secrecy laws do not inhibit implementation of the FATF Recommendations.

Financial institutions should not keep anonymous accounts or accounts in obviously fictitious names.

Financial institutions should undertake customer due diligence measures, including identifying and verifying the identity of their customers, when:

Establishing business relations;

Carrying out occasional transactions above the applicable designated threshold or that are wire transfers;

There is a suspicion of money laundering or terrorist financing; or

The financial institution has doubts about the veracity or adequacy of previously obtained customer identification data.

Financial institutions should pay special attention to all complex, unusual large transactions, and all unusual patterns of transactions, which have no apparent economic or visible lawful purpose.

If a financial institution suspects or has reasonable grounds to suspect that funds are the proceeds of a criminal activity, or are related to terrorist financing, it should be required, directly by law or regulation, to report promptly its suspicions to the financial intelligence unit

Financial institutions should develop programmes against money laundering and terrorist financing. These programmes should include:

The development of internal policies, procedures and controls, including appropriate compliance management arrangements, and adequate screening procedures to ensure high standards when hiring employees.

An ongoing employee training programme.

An audit function to test the system.

FATF assesses each member country against these recommendations in published reports. Countries seen as not being sufficiently compliant with such recommendations are subjected to financial sanctions.

Chapter 2: Regulatory background


1.3 Nigeria

Nigeria has comprehensive anti-money laundering legislation.

The Money Laundering (Prohibition) Act 2011 (as amended in 2012) contains the primary Nigerian anti-money laundering legislation.

It requires businesses within the regulated sector (banking, investment, money transmission, certain professions, etc.) to report to the authorities suspicions of money laundering by customers or others.

Money laundering is widely defined in Nigeria to include any handling or involvement with the proceeds of any crime as well as activities which would fall within the traditional definition.

Money laundering is prohibited in Nigeria.

It is an offence to:

conceal or disguise the origin of;

convert or transfer;

removes from the jurisdiction; or

acquire, use, retain or take possession or control of, any fund or property, which is known or reasonably ought to have been known to be the proceeds of an unlawful act.

Unlawful acts are defined very widely and would include tax evasion and securities fraud.

1.4 Specific rules on cash transfers

Cash payments exceeding N5,000,000.00 in the case of an individual, or N10,000,000.00 in the case of a body corporate are illegal unless made through a financial institution.

Any cash transfer to a foreign country exceeding $10,000 transfer mus t be reported to the Central Bank of Nigeria within 7 days from the date of the transaction.

Transportation of cash or negotiable instruments in excess of US$10,000 or its equivalent by individuals in or out of the country must be declared to the Nigerian Customs Service.



1.5 Specific rules with regard to financial institutions and designated non-financial institutions

There is a significant burden based on financial institutions and designated non-financial Institutions (referred to as regulated entities in the following description).

Definition: Designated non-financial institution

Designated non-financial institutions includes dealers in jewellery, cars and luxury goods, chartered accountants, audit firms, tax consultants, clearing and settlement companies, legal practitioners, hotels, casinos, supermarkets, or such other businesses as the Federal Ministry of Commerce or appropriate regulatory authorities may from time to time designate

Identification of customers

Regulated entities must identify customers and verify their identity using reliable, independent source documents. In addition they must identify and verify the identity of any beneficial owner.

Regulated entities must undertake customer due diligence measures when:

establishing business relationships;

carrying out occasional transactions above the applicable designated threshold prescribed by relevant regulation;

carrying out occasional transaction that are wire transfers;

there is a suspicion of money laundering or terrorist financing, regardless of any exemptions or thresholds; or `

the company has doubts about the veracity or adequacy of previously obtained customer identification data.

Due diligence

Regulated entities must also:

conduct on-going due diligent on a business relationship;

scrutinize transactions undertaken during the course of the relationship to ensure that the transactions are consistent with the institution’s knowledge of their customer their business and risk profile and where n

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